THE CASH-KING PORTFOLIO
by Tom Gardner (TomG@fool.com)
"It's not the bank robbers. No, it's the investment bankers who should be wearing the masks."
-- Warren Buffett
Captiva Island, FL (Dec. 4, 1998) -- As expected, last night's report generated as much e-mail as did our previous segments of Eyes on the Wise.
You'll remember that in our first installment, we exposed that Mario Gabelli's mutual funds are 0-for-17 in trying to beat the S&P 500 over the past five years. Mr. Gabelli assures us, though, that "these funds are not designed to beat the market. They're designed to make you rich."
And thus the $500 million valuation placed on Gabelli Asset Management by underwriter Merrill Lynch.
In our second installment, we took a look at the financial analyst on Wall Street and a few of the conflicts of interest facing folks like Tom Kurlak at Merrill Lynch. The Street.com landed a great interview with Mr. Kurlak who confessed to being "human" on his Intel calls this year. We're pleased to see acknowledgement of error -- heck, we all make them all the time.
That said, until we Fools see accountability pressed on the world of Wall Street research, we're henceforth referring to these analysts as Sales Analysts (SA) -- to use a pleasant acronym. We have no choice but to believe that analysts today are responsible primarily to the sales force and its need to generate commissions.
In yesterday's third installment, we were reminded by a former broker -- V. -- to be vigilant in any dealings with the full-service brokerage industry. His report seemed to echo the words of our Fool Radio's "Spy on the Wise" -- our Fool inside of the financial industry -- who warned individuals to know how much they're paying for the investment products they buy. Our Spy called on the brokerage industry to state the "net rate of return" on client statements, and to relate the equities portion of the account to the S&P 500's return. The net rate of return is what counts, and what the SEC should require from all brokerage statements today.
As expected, yesterday's article by our former broker "V." drew responses from all sides. I'll start with three notes sent to me from the industry side, then a few notes from individual investors (including an email from another former broker), and then we'll close up this week with our Part 2 installment of Eyes on Brokers. Please note that we have opened a message folder on the Web to continue this discussion: Eyes on the Wise. I hope you'll jump in.
In response to yesterday's article, Pro Charo J. wrote:
"V's tale is very old news, and does not reflect the training a broker goes through, or the sales practices at the big Wall St. firms today. He's dating himself when he speaks of selling limited partnerships. Those things have been history since 1991-92, when the Prudential partnerships started to blow up. I suspect he has been out of the business for at least 10 years."
Pro Steve B. wrote:
"V. failed in the business. All the failures go to work for a bank or Schwab. Think about it. Those brokers that are good and successful make a generous living. The rest work for a bank."
Pro Cameron B. wrote:
"The challenge for the brokerage industry is to motivate these people and to keep them focused on the long-term good they are working towards. To that end, there is a focus on commissions and generating business because that is the only way to assure that the broker is progressing on the correct path. However, I have NEVER seen a brokerage firm, especially a large national firm, that would EVER put sales promotion in front of the good of the client. This would only serve to ruin the firm's reputation and destroy their potential for future business. This business is built upon trust, pure and simple."
Among individual investors, Fool Kevin G. wrote,
"Reading tonight's report on stockbrokers, the one thing that kept going through my mind was 'Used Car Salesmen.' Thanks for the great insight."
Fool John M. wrote:
"My working partner Larry (a devoted Fool) and I preach self-directed investing and Fooldom at work. It amazes me how many people know so little about the investment options available to them and what really goes on with mutual funds. Professional financial management is too much in it for their financial gain first and yours second. Keep up the good work and Fool on!"
And Fool Eric T., himself a former broker, wrote:
"I have worked as a broker, and I found myself in an office full of salesmen and saleswomen, period.
Fools, in that environment, I hope we can all understand what our Spy on the Wise was telling us two days ago. It is absolutely critical that every individual working with a broker or financial consultant understand that their role may have a very strong sales component to it. And every individual should require a record of the Net Rate of Return on their investments.
I would never suggest that there isn't room in the financial world for salesmen. But I do believe that just like mutual funds and financial analysts, brokers need to be held accountable for their clients. We need to spread our Foolish Eyes around. A broker's performance versus the market's average returns must be made visible to clients -- if not made publicly available.
This would only help to ensure that the "trust" which Cameron B. claims that the financial industry is built upon is used to end the reproachable churning by the brokers that Eric T. describes above. Without that, individuals have little recourse but to believe that the financial services industry was actually built on the average Americans' ignorance about the subject of money, rather than their trust.
I think we all agree on that.
With those notes as our backdrop, it's time for the final installment of Eyes on Brokers. Without further ado, I again introduce -- V.
Yesterday, I talked about brokerage training and my daily routine at The Firm. Today, I'd like to start with those oh-so-sweet, nearly irresistible...
Sounds great, doesn't it?
Yes. It does sound great.
But I particularly disliked the Tuesday work nights when we were given the list of stocks that the firm had in inventory, which we could offer to our clients commission-free. Our firm of course compensated brokers for these trades -- actually, more than a normal reward -- and the client saw no commission appear on the confirmation. Now there's a good reason to buy a stock! You can, of course, bet that if the stock was stuck in our inventory (previously unsellable), then getting it at no commission was hardly a bargain.
Most clients had no clue of this.
So, from 6 p.m. to 8 p.m. we would telephone prospects at home during dinner, with this fantastic opportunity that just couldn't wait until tomorrow! "No, Mr. Jones, I don't have a fair-price target on it, but New York likes the stock a lot, and heck, it's commission-free if you buy it tonight."
What a deal.
There were also the occasional sales contests for brokers, like the time a new government-securities mutual fund was rolled out. The fund invested in securities issued or backed by the full faith and credit of the U.S. Government and paid a higher interest rate than our firm's money market fund (hmm, did I mention market risk?). And, lucky customers, we were to tell them that there was no charge to transfer money into it (oops, did I mention the 12b-1 fees or deferred sales charge?).
Our managers provided us with a printout of all of our clients' money market balances and instructed us to start calling. After all, we were told, these non-investment savvy clients had money that could be earning 2% - 3% more. It would be irresponsible of us not to pitch them the new fund -- fees and all. The sales manager paced around the office jingling a bag full of coins as our progress was monitored. Each time we successfully sold someone on the fund, we received a bright and shiny, freshly-minted Susan B. Anthony dollar.
Pavlov was right.
By now you should have the impression that the typical broker is all about selling and generating commissions, either because of the quotas established by the firm or due to their own drive. Many have no other way to make a six-figure income. Most have college degrees, but not all. Any sort of financial training for the broker paid on commission really isn't as pertinent to her success as the need to make money... the love of selling.
A hungry broker is an aggressive broker.
For example, one day the manager asked that we turn in a list of things that we wanted to own in the coming year: a new car, boat, house. The theory here being that the greater one's financial obligations, the harder they are likely to work. My list was frowned upon. I listed that I wanted to save and invest.
Foolish of me. What a blunder.
It was during my third year that the firm implemented a new policy on commission payout. Typically, a broker keeps between 30% and 40% of the commissions generated. But the new policy reduced this payout to between 0% and 20% on trades under a certain level. In addition, accounts that had no activity for the past twelve months were assessed a maintenance fee -- under the presumption that it was good for clients to trade more? Hmm.
This did not go over well with all of our customers. We were expected to call our clients and attempt to tactfully say, in effect, "Suzanne, either buy or sell something and generate a commission, or we'll have to generate it ourselves with a fee charged to your account." The firm was basically penalizing brokers for having small or inactive clients.
No Cash-King investor need apply.
Stockbrokers are first and foremost salespeople. The industry is built on this. I, and many others, view this as a conflict of interest. I believe that how they are compensated runs contrary to their fiduciary obligation to clients -- in a series of small and very large ways. Just think about the ongoing trading costs eating into the real rewards of compounded growth and you'll see that we're talking about no small violation of fiduciary duty from one client account to the next.
Now some firms, to help resolve this conflict, have developed managed asset accounts, where clients' money can be invested in up to one thousand different no-load mutual funds for which the firm charges an annual fee of up to 1.25%. Interesting. So, now you can invest in mutual funds (of which 90% underperform the indexes) and pay your broker a fee for his Wisdom and counseling (this, in addition to each of the funds' management fees & annual expenses).
I'm not sure that is the solution.
Some of you may now be thinking, "Hey, how could a broker survive with the proliferation of discount commissions and no-load mutual funds?"
Well, according to one veteran broker I overheard at lunch the other day, no-load funds will, in the long run, cost more than load funds. I scratched my head about that one. Gee, they'd have to hide a lot of fees to get there.
I asked myself: Did the veteran broker really believe this or was it simply part of the sales pitch in the firm? But wait, I realized, he must know what he is talking about. After all, he is a senior vice president with his firm, which brings me to a final point. How do brokers get to be VPs? Is it investment knowledge? Testing? The amount of wealth they've generated for clients?
No. Sadly it's based on commissions generated per years of service. Now, one would think that in the financial services industry, the Peter Principle would prevail. It says that employees will advance to their level of incompetence, and then fail.
Given this, you would think that as brokers climbed the ranks through selling more and more, they'd begin to lose clientele. I doubt this very seriously. I question whether the average person that turns his fate over to a broker even knows how he is performing versus the market's average. I know that some brokers will say that the VPs have risen through quality performance for their clients. Rather than argue this point, why don't the firms just publicly list the annualized investment performance, broker by broker. That way customers can understand how and why promotions and compensation are doled out in the industry.
By now you're probably wondering what all of this has to do with the Cash-King portfolio. Well, if you're a Cash-King investor, you are not a good prospect for most brokers, at least not as a long-term client.
Bottomline, the only person that can take personal and unbiased interest in your investments and hence your future is you. Even if you work with a professional, you must be vigilant. Ask questions. Get performance reports. It's your nestegg, college savings, and retirement. Remember that generating unnecessary and excessive commissions, capital-gains taxes, losses, or short-term gains adds nothing to achieving your goals. In addition, the only thing worse than an ill-informed investor, is one that thinks he knows it all, but actually doesn't.
I personally have learned ten times more in my three years of reading and following The Motley Fool than I ever did in my three years as a stockbroker. I still don't know it all, but I learn a little more each day. In fact, perhaps the Gardners' next book should be titled You Can Know More Than You Think, because if you follow the Foolish plan, you'll know more than the majority of stockbrokers. I'm sorry to sound so outlandish there, but it's simply true.
The Dow Dividend Approach coupled with Cash-Kings is the core to my investment plan. I have more exciting holdings in some of the Fool Port and Foolish Workshop mechanical picks, but the Dow Dividend/Cash-King combination provides my base.
With that I'll close and leave you with the top ten reasons to take charge of your finances and the reasons that I think Cash-King Investing makes so much sense:
Fool on and thanks for having me!
I presume this column and this week's reports will inspire some (or many) to share their insights into this industry -- both from the inside and outside of it. The Motley Fool is all about open dialogue, free thinking, and learning about this subject together. I expect that the Eyes on the Wise message folder will help hold the industry accountable, as well as remind us that there are many great financial professionals in every rank, but that, in many cases, the system obscures their hard and honorable work.
Please drop by the Eyes on the Wise folder if you're moved to speak. And Fool on!
Order your copy of David and Tom Gardner's new book, Rule Breakers, Rule Makers, in advance. This Simon & Schuster beauty doesn't arrive until January, but you can reserve your copy today! The first half of the epic book, on Rule Breakers, elucidates the Fool Port's investment style; the second half, on Rule Makers, further explains Cash-King investing.
Day Month Year History C-K +1.98% 1.98% 24.16% 24.16% S&P: +2.30% 1.11% 16.95% 16.95% NASDAQ: +2.50% 2.75% 20.21% 20.21% Cash-King Stocks Rec'd # Security In At Now Change 2/3/98 24 Microsoft 78.27 127.38 62.74% 5/1/98 55.5 Gap Inc. 34.06 50.56 48.45% 2/13/98 22 Intel 84.67 116.31 37.36% 2/3/98 22 Pfizer 82.30 112.63 36.85% 6/23/98 34 Cisco Syst 58.41 78.25 33.97% 8/21/98 44 Schering-P 47.99 54.75 14.08% 2/6/98 56 T. Rowe Pr 33.67 37.53 11.46% 2/27/98 27 Coca-Cola 69.11 69.00 -0.15% 5/26/98 18 AmExpress 104.07 98.63 -5.23% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Eastman Ko 63.15 73.56 16.49% 3/12/98 20 Exxon 64.34 71.50 11.14% 3/12/98 15 Chevron 83.34 81.69 -1.99% 3/12/98 17 General Mo 72.41 69.50 -4.01% Cash-King Stocks Rec'd # Security In At Value Change 2/3/98 24 Microsoft 1878.45 3057.00 $1178.55 5/1/98 55.5 Gap Inc. 1890.33 2806.22 $915.89 2/13/98 22 Intel 1862.83 2558.88 $696.05 6/23/98 34 Cisco Syst 1985.95 2660.50 $674.55 2/3/98 22 Pfizer 1810.58 2477.75 $667.17 8/21/98 44 Schering-P 2111.7 2409.00 $297.30 2/6/98 56 T. Rowe Pr 1885.70 2101.75 $216.05 2/27/98 27 Coca-Cola 1865.89 1863.00 -$2.89 5/26/98 18 AmExpress 1873.20 1775.25 -$97.95 Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Eastman Ko 1262.95 1471.25 $208.30 3/12/98 20 Exxon 1286.70 1430.00 $143.30 3/12/98 15 Chevron 1250.14 1225.31 -$24.83 3/12/98 17 General Mo 1230.89 1181.50 -$49.39 CASH $120.62 TOTAL $27138.03 *Please note: On 8/4/98 $2,000 cash was added to the
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